Transcript ENERGY-ALIGNED LEASE LANGUAGE Solving the Split Incentive Problem Energy retrofits can: Save building owners and tenants money. Improve reliability and occupant comfort. Create green.

ENERGY-ALIGNED LEASE LANGUAGE
Solving the Split Incentive Problem
Energy retrofits can:
Save building owners and tenants money.
Improve reliability and occupant comfort.
Create green jobs in the community.
Reduce greenhouse gas emissions.
But…
Misaligned incentives can get in the way.
A “misaligned incentive,” often called a “split incentive”: a transaction where
the benefits do not accrue to the person who pays for the transaction.
The split incentive problem in energy: the building owner pays for retrofits, but
cannot recover savings from reduced energy use that accrue to the tenant.
Owner invests
capital
Retrofits reduce
energy use
Tenant receives
benefits
In typical New York City modified gross leases, the savings from energy retrofits
are passed through to the tenants:
• It is not in the owners’ immediate interest to invest capital in improvements.
• Thus energy savings are left on the floor.
More specifically, the split incentive impedes cost
recovery.
Owners can currently pass through capital expenses. However, recovering the cost:
Owner
Retrofits
Tenant
• across the useful life of the equipment is too long to justify large upfront
investments.
• based on the actual energy savings is considered too complex to measure.
• based on predicted energy savings leaves tenants at risk for energy retrofits
that underperform.
The split incentive problem is not just a theory.
Commercial Real Estate Owners
Inhibited by the Split Incentive Problem
In a NYC Mayor’s Office survey of commercial property owners, 60% of
respondents stated that the split incentive problem inhibits them from
undertaking energy retrofits.
The respondents included firms that own or manage over 310 million
square feet of commercial space in NYC.
Prototype lease language was developed.
In 2010, the Mayor’s Office assembled a small working group to work for six
months on lease language that would address the split incentive problem.
The group, led by an experienced real estate lawyer, was composed of some of
the city’s largest owners, tenants, management companies, and engineers,
including:
Marc Rauch, Esq.
Forest City Ratner Companies
Deutsche Bank
Ernst & Young
Cushman & Wakefield
First New York Partners
Goldman Copeland Associates
JB&B
The lease language needed to address specific issues.
Issue: Owners wanted
to base cost recovery on
savings predicted by an
engineer.
Issue: Tenants did not
want to base payback
on predicted savings
that might not be
realized.
Issue: Industry
experience showed that
actual savings are
generally within +/- 20%
of predicted savings.
Solution: Base owners’ cost recovery on predicted savings as long as tenants
are protected against underperformance.
Energy-Aligned Lease
Base owners’ cost recovery on predicted savings, but limit owners’ capital
expense pass-through to 80% of such predicted savings in any given year.
The resulting lease language is easy to use and can be
downloaded from the Web.
• Leasing language and explanation of how the lease works are available at
www.nyc.gov/ggbp.
The lease language includes several key features:
• The predicted savings are determined by an energy specialist agreed upon by
both parties.
• Tenants are protected from underperformance by a 20% “Performance Buffer.”
• Owners are paid back in full, but the payback period is extended by 25%.
• Language can be easily inserted into typical modified gross commercial leases.
Key
Conclusion
Energy retrofits are not a zero sum game: with
aligned incentives, both tenants and owners win.
This lease language does not include the following:
It does not solve the split incentive problem for electricity used by
equipment within tenant spaces when such spaces are not individually
metered or sub-metered.
• To solve this problem, tenants must be individually metered or
sub-metered, and be billed accordingly.
• By 2025, all large commercial tenant spaces in NYC must be
provided with meters or sub-meters under Local Law 88.
A financial model was developed to demonstrate the lease
language’s potential performance.
The Mayor’s Office created a
financial model to see how energy
efficiency dollars would flow in
high, low and expected retrofit
performance scenarios based on
key input variables*, such as:
• Overall rent
• Operating expenses /
escalation rate
• Projected energy savings
• Performance buffer
percentage
*All inputs and assumptions shown in this
table (except year of implementation and
retrofit cost per square foot) provide the basis
for the charts that follow.
INPUTS & ASSUMPTIONS
Tenant lease info
Gross square footage
Lease term (yrs)
Lease rent psf
OpEx base year psf
OpEx base year - non energy
OpEx base year - energy
OpEx projected escalation % - non energy
OpEx projected escalation % - energy
$
$
$
$
EE measures
Lease year during which EE measures are implemented
First Comparison Year after implementation
Retrofit cost psf
Retrofit cost (tenant space's proportionate share)
$
$
Annual energy savings psf
Projected energy savings (%, bundled)
Projected energy savings psf (in dollars)
Projected simple payback period (yrs, bundled)
Performance Buffer
Adjusted Payback Period (reflecting Performance Buffer)
$
Range of deviation from projected energy savings
Savings in Under-Performing scenario
Savings in Over-Performing scenario
100,000
10
60.00
15.00
13.00
2.00
3.00%
3.00%
1
2
2.50
250,000
20%
0.41
6.1
20%
7.6
20%
16%
24%
Other
Discount rate (NPV)
Annual % degradation of energy savings
5.00%
1.00%
KEY
Input
Fixed
Calculated
The model shows pro-forma realized savings per square
foot and energy savings NPV.*
OUTPUT – NPV/GRAPHS
The model shows how much
savings are realized each year for
Tenant and Owner.
The model demonstrates NPV
realized by both Tenant and
Owner.
*The model includes 3 scenarios for each transaction: (i) retrofit performs in line with projected savings; (ii) retrofit
under-performs projected savings by an adjusted %; and (iii) retrofit over-performs projected savings by an adjusted %.
The performance buffer reduces Tenant’s downside risk.*
If the retrofit
underperforms by 20%:
Without the
performance buffer, the
tenant pays an additional
modest amount for
energy in the early
years, still saving in the
out years.
With the performance
buffer, the tenant
benefits from the
beginning of retrofit
installation.
*Assumptions include retrofit per
square foot cost of $2.50, and
projected energy savings of 22%.
Tenant realizes net savings even with retrofit late in lease.*
*Assumptions include retrofit per square foot cost of $2.50, and projected energy savings of 22%.
Even in the Trifecta (Long pay-back period, late in lease,
underperformance by 20%), the tenant stands to gain.*
*Assumptions include retrofit per square foot cost of $2.50 and projected energy savings of 22%.
• Even with a 15 year pay back retrofit occurring in Year 7 of a ten-year lease
and underperformance by 20%, the tenant still realizes positive NPV.
• Long pay-back retrofits can still benefit tenants, and tenants can be
protected from down-side risk.
• Summary: Down-side risk to the tenant is negligible.
Financial risk to tenant is extremely low.
Example of retrofit costing $2 per square foot for a 200,000 square foot lease, with 25% projected
energy savings:
Simple payback = $0.50 per square foot over 4 years; Adjusted payback (80% Amortization) = $0.41
per square foot over 5 years.
• The cost associated with the typical error margin of
+/- 20% for energy retrofits is diminutive compared
to total rent and operating expenses.
• Error margin is less than a fifth of one percent of
total rent (0.17%); and tenant is protected by
performance buffer (i.e. 80% of payback
amortization).
• Even if total cost of retrofit were lost, this is less
than three quarters of a percent of total rent
(0.69%).
Tenant's Annual Downside
OpEx Base
OpEx Base
Proportionate
Energy
Year (Non Year (Energy) Share of Retrofit
Savings
Lease Rent Energy) Cost
Cost
Cost
Uncertainty*
Per sf
$60.00
$13.00
$2.00
$0.41
$0.10
As %
100%
21.67%
3.33%
0.69%
0.17%
$400,000
$82,400
$20,600
Total
$12,000,000 $2,600,000
Cost
*i.e., Amount of Performance Buffer as % of annual base rent.
This language has been used at 7 WTC and is broadly
endorsed.
On April 5, 2011, Silverstein Properties and WilmerHale signed a lease
modeled after the energy-aligned lease for 210,000 sq ft. of space in 7
WTC.
The City of New York has agreed to use the language whenever NYC
is a tenant.
“REBNY… will be recommending this language to all of our members.”
-Steven Spinola, President, REBNY
Other leading organizations endorsing the language include:
This is not a zero sum game: Both tenants and owners
benefit from energy retrofits.
• The 20% performance buffer removes down-side risk for tenants
under most scenarios.
• Tenants can accrue net savings even if retrofit occurs late in lease or
has a long pay-back period.
• Tenant risk from drastically underperforming retrofit is minimal
because retrofit expense is dwarfed by overall rent expense.
• Owner has an interest in correcting problems and maintaining retrofit
performance to accrue savings later on and to increase building value.